Finding gems outside the ASX top 20

By Julian BeaumontMarch 2016min read

To properly diversify in Australian stocks, it is necessary to look outside the largest stocks.

Not many major world sharemarkets are as concentrated as Australia’s. By market value, the local market is dominated by a mere handful of large stocks that have a disproportionate influence on the market’s performance.

At present, the top 20 stocks account for more than 60 per cent of the market’s total value, which means that ASX share investors have, on average, more than 60 per cent of their investment in a group of behemoths that include the big four banks, Telstra and BHP Billiton. How their portfolios perform is largely determined by these top 20 stocks.

The appeal of the top 20

There are some good reasons for investors’ heavy exposure to the top 20. Many take comfort in owning these large, mature blue chips and may not be familiar with the opportunities beyond the top 20. Others find favour in the attractive yields they typically offer, particularly in our current low interest rate environment.

Previously, investors sought yield through term deposits. Now many do so through investing in the banks themselves, gaining higher dividend yields. Consensus broker estimates indicate the big four banks offer an average prospective fully franked dividend yield in excess of 6 per cent. Grossed up for franking credits, the banks yield closer to 9 per cent.

Regardless of the reasons, many investors have funnelled their investment into the top 20 and as a result have a portfolio overexposed to Australian banking, with perhaps resources and telecommunications representing the extent of their diversification.

Professional investors call this concentration risk and in many instances it’s a case of investors holding too many bank stocks. Professional investors such as fund managers face continual scrutiny over their relative performance, which is compared to the market index. This inevitably influences them to hold the largest stocks of the index itself. If a small group of large stocks drive index performance, fund managers cannot afford not to own them.

Retail investors do not have to worry about this. In this sense, they have an advantage over professional investors in being able to ignore the index. You should aim to invest in stocks that make the most sense, regardless of their size, and which provide genuine portfolio diversification.

Diversification, through building a balanced portfolio, is the most prudent strategy to protect and build an investment over the long term.

(Editor’s note: Do not read the following ideas as stock or sector recommendations. Do further research of your own or talk to a licensed financial adviser before acting on the themes in this story).

Looking outside the top 20 stocks

To properly diversify in Australian stocks, it is necessary to get out of the top 20. Doing so will enable you to find a much wider range of sectors in which to invest. Only among the ex-20 stocks will you find sectors such as infrastructure (which includes exposure to airports, toll roads and ports), technology, food and beverage, specialty retailers and professional services. Even for sectors represented in the top 20, the choice among the ex-20 stocks is far greater, allowing investors to very specifically refine their exposures.

For example, there is just one healthcare company in the top 20 – the global bio-pharmaceutical giant CSL, which is celebrating its 100th year of business and has a market valuation of about $50 billion. Among the ex-20 stocks there are a number of healthcare companies ranging from similarly mature companies (e.g. Ramsay Health Care, which operates private hospitals) to early stage bio-techs that could quite conceivably become the next CSL in time.

Ex-20 stocks also tend to be less correlated to macro-economic drivers. Whereas banks depend on credit cycles and resources companies depend on global commodity prices, smaller companies tend to be more in control of their own destiny. Their performance on the sharemarket will depend less on the latest economic data point coming out of China or the RBA, and more on headlines about a milestone or entry into a new market.

Winning with research

It is at this level of the sharemarket that market concentration works for you: with most of the investment flowing into the top stocks, so too does most of the research. In fact, there is a surprising level of investor ignorance of the stocks outside the top 20.

This information gap in the market means that a dedicated specialist investor can find the kind of opportunities that simply cannot be found in large, well-known stocks.

There is a stock-picker’s paradise outside the top 20. If you can take the time to explore the smaller-cap stocks and carefully select a few of the better opportunities, the long-term returns can be spectacular if you get it right. At the start of 2000, for example, Ramsay Health Care traded for $1 a share. It now changes hands for more than $60.

Specialist managers do the work for you

Of course, investing outside the apparent safety of blue chip stocks can go badly wrong too. They can be illiquid at times and are usually more volatile than the larger-cap stocks.

Being a riskier sector than the large-caps, there is a good case for using a specialist fund manager when it comes to investing in ex-20 stocks. There is a thriving population of such specialist funds, with their fund managers spending their time researching the stocks thoroughly, putting together a diversified portfolio, and monitoring their every move.

Investors effectively back the investment skill of the fund manager. Doing this well is often considered to be as much an art as it is a science, and the best managers do it very well.

Conclusion

While investors are justified in seeking out the opportunities and diversification on offer beyond the top 20, it can be an intimidating expansive space. Considerable skill and effort are essential.

An ex-20 Australian equities strategy presents a compelling proposition for investors and, not surprisingly, is attracting a growing investor audience. It offers a complementary alternative to the traditional managed funds, harnessing the potential that lies within the broader market but outside the top 20.

About the author

Bennelong Funds Management is a foundation member of mFunds. mFunds are unlisted managed funds you can invest in through ASX’s mFund Settlement Service.

This article appeared in the March 2016 ASX Investor Update
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This article appeared in the March 2016 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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